A Thought Experiment

“To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”--Warren Buffett

In today’s world it is likely that you are your own financial risk manager. There is no free lunch. Risk and reward both come with associated costs. Learning how to evaluate these costs and making wise decisions are an essential part of building net worth and reaching particular financial goals in the different seasons of your life. On the one end are futures contracts and options. On the other end are fixed annuities sold by insurance companies. What is right for you? When listening to salesmen and financial teachers how can we evaluate their competing claims?

As regular readers know, I find it disturbing that in Dave Ramsey’s teaching he insists on projecting a 12% return on retail mutual funds and recommending 100% all in stocks at all times, rather than the more usual recommendation of a mixture of bonds, stocks, cash, gold, and foreign currency based on age, income, and tolerance for risk.

Consider the following thought experiment.

I will give you a check for $5,000 if you guarantee to give me $17,426.78 ten years from the date of agreement. That is 12% compounded quarterly (dividends are normally distributed on a quarterly basis) according to Bankrate’s simple savings calculator. If Dave Ramsey is correct, you could go out and put it into any 4 mutual funds that meet his criteria with a near certainty of making money.

Dave Ramsey states that there is a 97% probability that if you accept this bet you will make a profit or at least break even. That is as close to a sure thing as you can get in this unhappy world. Just imagine that you are blindfolded. You place you hand in a vase that contains 97 blue marbles that tell you how much money you win and only 3 black marbles that tell you that you have lost money.

But no reasonable person would take the bet I have offered because he or she would believe the risk of losing money exceeds the potential of making money. However, there is some point at which this becomes a fair bet. A fair bet is defined as a proposed bet in which a reasonable man would be just as likely to choose one side of the bet as the other side of the bet.

For example, I might take either side of that bet maybe somewhere between 3% and 5% return. I would have to think about it. Above 5% I think I would always take the guaranteed return. Below 3% I think I might make the offer to you, though on a limited basis.

In financial terms, what I have proposed is a Dave Ramsey Bond, guaranteed by his good name and personal fortune. You will notice there are not very many bonds that offer a 12% rate of return. Those that do offer a return of 12% or more have a name, junk bonds.

This post is inspired by a retirement article from Kiplinger published by Yahoo and my reading of The Plight of the Fortune Tellers by R. Rebonato, a difficult but stimulating read.